Govind Gurnani

Insights : Financial Derivatives And Credit Derivatives In The Banking

Sector

Financial Derivatives

Derivatives, are risk management financial instruments, which derive their

value from an underlying asset. The underlying asset can be stocks, currencies,
commodities, indices, and even interest rates.

There are four types of financial derivatives: Forwards, Futures, Options and
Swaps. Financial derivatives are used for a number of purposes including risk
management, hedging, arbitrage between markets, and speculation.

Financial derivatives contracts are usually settled by net payments of cash. This
often occurs before maturity for exchange traded contracts such as commodity
futures. Cash settlement is a logical consequence of the use of financial
derivatives to trade risk independently of ownership of an underlying item.

1. Forward Contracts
Forward contracts mean two parties come together and enter into an agreement
to buy and sell an underlying asset set at a fixed date and agreed on a price in
the future.

In simple words, it is an agreement formed between both parties to sell their

asset on an agreed future date.

The forward contracts are customised and have a high tendency of counterparty
risk. Since it is a customised and over the counter contract, the size of the
agreement entirely depends on the term of the contract.

2. Future Contracts
Future contracts refer to an agreement made by the two parties to buy or sell an
underlying instrument at a fixed price on a future date.

The size of future contracts is fixed, and it is regulated by the stock exchange
just because it is known as a standardised contract.

Since these contracts are standard and are listed on the stock exchange, they
cannot be changed or modified in any possible way.
In simple words, future contracts have pre-decided size, pre-decided expiry
period, pre-decided size. In futures contracts, an initial margin is required
because settlement and collateral are done daily.

3. Option Contracts

Options contracts provide the right but not the commitment to buy or sell an
underlying instrument.

Option contracts consist of two options:

▪ Call Option
▪ Put Option

In call option, the buyer has all the right to purchase an underlying asset at a
fixed price while entering the contracts. While in put option, the buyer has all
the right but not obligation to sell an underlying asset at a fixed price while
entering the contract.

4. Swap Contracts

Swap contracts mean the agreement is done privately between both parties. The
parties who enter into swap contracts agree to exchange their cash flow in the
future as per the pre-determined formula.

Under swap contracts, the underlying security is the interest rate or currency, as
these contracts protect both parties from several major risks.

These contracts are not traded to the stock exchange as investment banker plays
the role of a middleman between these contracts.

Credit Derivatives

Credit Derivative refers to a derivative contract whose value is derived from

the credit risk of an underlying debt instrument. A credit derivative allows
creditors to transfer the potential credit risk to a third party, in exchange for a
fee, known as premium. The value of a credit derivative is dependent on both
the credit quality of the borrower and the third party, referred to as the counter
party. Credit Default Swap, Collateralised Debt Obligation and Collateralised
Loan Obligation are some of the credit derivatives in the market.
A. Credit Default Swap
Credit Default Swap (CDS) is a credit derivative contract in which one
counter party (protection seller) commits to compensate the other counter party
(protection buyer) for the loss in the value of an underlying debt instrument
resulting from a credit event with respect to a reference entity, and in return, the
protection buyer agrees to make periodic payments (premium) for buying the
CDS to the protection seller until the maturity of the contract or the credit
event, whichever is earlier.

A CDS is a tool to transfer and manage credit risk in an effective manner

through redistribution of risk. A CDS is an insurance against the loss from
default in the payment of underlying debt instrument of a reference entity. CDS
can be structured either for the event of shortfall in principal or shortfall in
interest.

The amount of premium is decided by the protection seller based on the

amount, term & rating of the underlying debt instrument, rating of the issuer of
the bond.

The debt instrument can be any of these instruments viz. commercial papers,
certificates of deposit, non convertible debentures of original maturity up to one
year etc.

Credit event means a pre-defined event related to a negative change/

deterioration in the credit worthiness of the reference entity underlying a credit
derivative contract, which triggers a settlement under the contract. Credit events
are agreed upon when the trade is entered into and are part of the contract.
There are different types of credit events such as bankruptcy, failure to pay and
restructuring. If the credit event does not occur before the maturity of loan, the
protection seller does not make any payment to the protection buyer.

Risks in the CDS : Counter party concentration risk and hedging risk are the
major risks in the CDS market.

Example of Credit Default Swap

Assume that Mr.Tom owns 8% 5 year bond of face value ₹ 25 crore issued by
XYZ Ltd. Tom enters into a five year CDS contract with Jerry for a face value
of bond and agrees to pay 100 basis points (i.e.1%) of the face value of bond
annually as premium to Jerry. Here, Tom is protection buyer and Jerry is the
protection seller and XYZ Ltd. is the reference entity. If the reference entity
does not default till the maturity of the bond, the Tom (protection buyer) keeps
on paying 100 bps of ₹ 25 crore, which is ₹ 25 lakh to the protection seller
every year. On the contrary, if the credit event occurs, the protection buyer will
be compensated fully by the protection seller for the agreed amount in CDS.
The settlement of the CDS takes place either through cash settlement or
physical settlement.

B. Collateralised Debt Obligation

Collateralised Debt Obligation (CDO) is a complex structured finance

product that is backed by a pool of loans and other assets and sold to
institutional investors. A CDO is a particular type of derivative as its value is
derived from another underlying asset. The underlying assets can be mortgages,
bonds or other types of debt. These assets become the collateral if the loan
defaults.

Mechanism of Issuance of CDO

▪ The assets that form the CDO are usually collected by an investment bank or
other financial institution and then sold to a special purpose entity (SPE). The
SPE is set up by the bank to purchase the assets from it. The assets are mostly
comprised of mortgage loans in the CDO.

▪ In order to fund the purchase of assets from the bank, the SPE sells
securities to investors. CDO allows investors to purchase a share of a
diversified underlying portfolio.

▪ The securities sold to investors are generally tranched, meaning that the
securities are divided into different classes or tranches* (viz. Senior, Mezzanine
and Equity) with varying risks and claims on the cash flows produced by the
underlying assets. [ *Tranches are pieces of a pooled collection of securities,
usually debt instruments, that are split up by risk or other characteristics in
order to be marketable to different investors. Tranches carry different
maturities, yields, and degrees of risk and privileges in repayment in case of
default.]

▪ The senior tranche of the CDO carry the lowest risk and hence, it receives
the low return. The mezzanine tranche of the CDO carry the modest risk &
receives the modest return. The equity tranche is the highest risk portion of the
CDO and hence, receives the higher return. Equity tranche is the first position
to bear any losses resulting from underlying asset pool and receives income
only after all other tranches of the security have been satisfied.
▪ The cash flows generated by the underlying assets are like a waterfall,
payments are prioritised first to highest tranches and anything remaining is paid
out of tranches that appear progressively lower in the hierarchy. If cash flows
from the underlying assets prove insufficient, the lower tranches are first to
suffer the losses and may not be paid at all.

Types of CDO
▪ Cash Flow CDO is a type of CDO that invests in cash generating assets
such as bonds, mortgages and loans.

▪ Synthetic CDO is a type of CDO that invests in non cash derivatives (viz.
credit default swaps, options, and other contracts) that offers extremely high
yields to investors. Unlike cash flow CDO, the synthetic CDO does not actually
have to own any underlying assets at all.

Advantages of CDO
restructuring. If the credit event does not occur before the maturity of loan, the
protection seller does not make any payment to the protection buyer.

Risks in the CDS : Counter party concentration risk and hedging risk are the
major risks in the CDS market.

Example of Credit Default Swap

Assume that Mr.Tom owns 8% 5 year bond of face value ₹ 25 crore issued by
XYZ Ltd. Tom enters into a five year CDS contract with Jerry for a face value
of bond and agrees to pay 100 basis points (i.e.1%) of the face value of bond
annually as premium to Jerry. Here, Tom is protection buyer and Jerry is the
protection seller and XYZ Ltd. is the reference entity. If the reference entity
does not default till the maturity of the bond, the Tom (protection buyer) keeps
on paying 100 bps of ₹ 25 crore, which is ₹ 25 lakh to the protection seller
every year. On the contrary, if the credit event occurs, the protection buyer will
be compensated fully by the protection seller for the agreed amount in CDS.
The settlement of the CDS takes place either through cash settlement or
physical settlement.
C. Collateralised Loan Obligation

Collateralised loan obligation (CLO) is a security or tradable financial asset,

that is backed by a pool of corporate loans having a low credit rating. The
underlying loans of a CLO are majority comprised of first-lien senior-secured
bank loans. A second lien and unsecured debt is also found in a CLO. The
payments made from various corporate loans are pooled together and then
transferred to multiple classes of owners in different tranches.

CLO Mechanism

▪ The procedure followed for creation of CLO and distribution of cash flows
from the underlying assets in a CLO to the investors is the same that is followed
in the case of CDO as explained the above. The difference under the CLO lies
in the underlying collateral assets. In the CDO, the underlying collateral assets
are mostly mortgage loans, whereas under the CLO, the underlying collateral
assets are first lien senior secured bank loans, which rank first in priority of
payment in the borrower’s capital structure in the event of bankruptcy, ahead of
unsecured debt.

▪ These senior secured bank loans from a diverse range of borrowers

(typically 150-200 companies) are pooled in the CLO and actively managed by
the CLO manager.

▪ CLO portfolios are actively managed over a fixed tenure known as the
‘reinvestment period’ (3 to 5 years) during which time, the manager of a CLO
can buy and sell individual bank loans for the underlying collateral pool in an
effort to create trading gains and mitigate losses from deteriorating credits.

▪ The investors under the CLO are paid from the cashflows that the
underlying loans generate. The cashflows from the underlying loans are
prioritised and the investors at top tranche in the tranche structure are paid first.
If cash flows from the underlying assets prove insufficient, the lower tranches
are first to suffer the losses and may not be paid at all.

Difference between CDO and CLO

▪ CDOs mainly have exposure to just one industry i.e. the housing market,
whereas CLOs usually have exposure to varying industries.
▪ CLO is relatively less intricate than CDOs. CDOs make use of many
derivatives such as credit default swaps, options, while CLOs are a combination
of underlying loans depending upon the varying levels of risk.
▪ The exposure of the banking sector in CLOs is relatively lesser than CDOs.

******************************